Everyone is missing the serious problem that ultra-low interest rates have created for retirees.
Pension funds are still assuming that future returns will be in the 7½–8% range. And as people get older and have no practical way to go back to work, pension funds that are forced to reduce payments in 10 or 15 years (and some even sooner) will destroy the lifestyles of many.
So what made Europe and Japan agree that negative rates-with all their known and unknown consequences—are a solution to our current economic malaise?
I have been trying to explain this by comparing economic theories to a religion.
Everyone understands that there is an element of faith in their own religious views, and I am going to suggest that a similar act of faith is required if one believes in academic economics.
Economics and religion are actually quite similar. They are belief systems that try to optimize outcomes. For the religious, that outcome is getting to heaven, and for economists, it is achieving robust economic growth-heaven on earth.
I fully recognize that I’m treading on delicate ground here, with the potential to offend pretty much everyone. My intention is to not to belittle either religion or economics, but to help you understand why central bankers take the actions they do.
The No. 1 Commandment of a Central Bank
Central bankers are always-and everywhere-opposed to inflation. It’s as if they are taken into a back room and given gene therapy. Actually, this visceral aversion is also imparted during academic training in the elite schools from which central bankers are chosen.
This is our heritage; it’s learning derived not only from the Great Depression but also from all of the other deflationary crashes in our history (not just in the US but globally).
When you are sitting on the board of a central bank, your one overriding rule is never to allow deflation to occur on your watch. No one wants to be thought responsible for bringing about another Great Depression.
And let’s be clear, without the radical actions taken in 2008–09 to bail out the banks, drop rates to the zero bound, and institute quantitative easing, we would likely have been facing something similar to the Great Depression.
While I don’t like the manner in which we chose to bail out the banks, some form of bailout was a necessary evil.
Whenever we enter the next recession, we are going to do so with interest rates close to the zero bound. Most of the academic research both inside and outside the Fed suggests that quantitative easing, at least in the way the Fed did it the last time, is not all that effective.
If you are sitting on the Federal Reserve Board, you do not want to allow deflation to happen on your watch. So what to do? You try to stimulate the economy. And the one tool you have at hand is the interest-rate lever.
Since rates are already effectively at zero, the only thing left is to dip into negative-rate territory. Because, for you, allowing a deflationary malaise to set in is a far worse thing than all of the potential negative consequences of negative rates put together.
It’s a Hobson’s choice; you see no other option.
Different Schools of Economic Thought
There are multiple competing economic theories on the government’s role in monetary policy making. The operative word is theories.
Each is an attempt to describe how to manage a vastly complex modern economy. Some see too much debt as the cause of our current malaise. Others think that lowering taxes would allow consumers and businesses to keep more of their income and hopefully spend it.
In the not too distant human past, shamans and soothsayers conjured theories about how the world worked and how to predict the future. Some examined the entrails of sheep, while others read meaning into the positions of the stars (or whatever their prevailing theory dictated) and told leaders what policies they should pursue.
An astute priest would pretty quickly figure out that the best route to priestly job security was to foretell success for the politician’s/king’s/tribal chief’s pet policy course.
In today’s world, economists serve exactly the same function. They skry their data sets—a latter-day version of throwing the bones—and then, based on the theory by which they believe the data should be interpreted, they confirm the orthodox policy choices of their political masters. And so their careers prosper.
This is not to disparage economists—not at all. They really do try to come up with the best possible policies—but the range of policy alternatives is constrained by the economists’ (and the general society’s) belief system.
If you believe in a Keynesian world, then you will prescribe lower rates and more fiscal stimulus during times of recession. If, however, you believe in a competing model, such as the Austrian theory postulated by Ludwig von Mises, then you believe that smaller government, far less fractional reserve banking (if any at all), and a gold standard are appropriate.
There are also other competing theories, each with its own model of how the world works, but I think you already got my point.
There’s No Right Answer in Economics – Just Faith in Theory
If we had adopted, for example, an Austrian model in 2008–09, we would have had a much deeper recession, and unemployment would have risen higher. The recovery, on the other hand, would theoretically have come more quickly as prices cleared and debt was resolved.
However, that period of time before the recovery began would have been devastating to the millions of families who would have faced even more crippling unemployment than we saw. That is an experiment we did not conduct, so we will never truly know whether that path might have been less painful in the long run.
Austrians are willing to face a series of small recessions as part of the price of maintaining a free economy, rather than postponing recession and trying to fine-tune what is supposedly a free market economy by means of monetary and fiscal policy.
An analogy would be the theory that allowing small and controllable forest fires today might prevent a large, utterly devastating forest fire in the future.
Nassim Taleb’s important book Antifragile makes a strong case that businesses, markets, and whole societies are much better off if they allow relatively minor random events, errors, and volatility to correct as quickly as possible… rather than continually patching them over to avoid short-term pain.
Decentralized experimentation in the economy by numerous complex actors capable of taking risks works better than a directed economy that encourages the buildup of excessive risk throughout the entire economy.
The problem is, there really is no one clearly right answer as to which economics belief system is best. I know what I believe to be the correct answer, but that belief is based on the way I understand the world—and the world is vastly more complex than anyone’s theory can be.
No theory allows for a perfect solution for all participants. Rather, each theory picks winners and losers, with the overall objective of creating an economy that has maximal potential to grow and prosper.